Harnischfeger Case

Group Members: Mark Breen Greg Callow Marv Franz Mary Mumcuoglu Tracey Weiler

Agenda

Case Facts Strategy Analysis Accounting Analysis Group Task Future Prospects for Harnischfeger Questions

Case Facts

Machinery Equipment 2 Segments-Heavy Equipment & Industrial Technologies Group (ITG) Expected growth in material handling & engineering services Financed rapid growth in 70s through debt leads to problems when market shrinks in 80s

Case Facts

Company ends up in violation of debt covenants Recovery plan

Change in management Cost Reductions Reorientation of Companys business Debt restructuring and recapitalization

Strategy Analysis

Industry Analysis: Macro

Improving general business conditions Drop in price of oil Supply side economics conservative fiscal policies Coming out of recession High interest rates

Strategy Analysis

Industry Analysis: Macro

Strategy Analysis

Industry Analysis: Macro

Strategy Analysis

Industry Analysis: Porters 5 Forces

Rivalry Among Existing Firms: High

Low growth for cranes & mining equip. Higher growth for ITG Concentration - Few firms Switching cost - High High fixed to variable costs - less for ITG High exit costs less for ITG Conclusion: Rivalry is High - less for ITG

Strategy Analysis

Industry Analysis: Porters 5 Forces

Threat of New Entrants: Low

High cost of establishing economies of scale High capital investment required Access to distribution channels is difficult Threat of new entrants is higher for ITG

Treat of Substitute Products: Low

Similar price and Performance Consumers willingness to switch products -Low

Strategy Analysis

Industry Analysis: Porters 5 Forces

Bargaining Power of Buyers: Low

Switching costs High Alternative products Few Importance of quality High Importance of cost High

Bargaining Power of Suppliers: Low

Switching cost Low Alternative products Many Quality and Cost considerations -High

Strategy Analysis

Industry Analysis: Porters 5 Forces

Overall: The market for cranes and mining machinery is less attractive than the market for ITG products & services The income statement of Harnischfeger will likely show losses or low profitability for the near future Therefore, Harnischfeger needs to be a low cost producer to survive

Strategy Analysis:

Competitive Strategy Analysis

Differentiation: Strategic shift from manufacturing cranes Still manufacturing mining equipment Low cost- Economies of Scale, Efficiency Concerns, Cost Control, Little differentiation

Strategy Analysis:

Competitive Strategy Analysis

New Strategy Focus on the high tech part of business Creation of ITG Differentiation High R&D required, Innovation, skilled staff, customization requires flexibility and customer service

Strategy Analysis:

Context for Accounting Analysis

Short term factors for success Maintaining financing/liquidity
-Look for accounting to improve revenue, cash flow, expense reduction, reported earnings Ex. Policy changes: revenue recognition, inventory, depreciation Estimates: allowances for reserves, pension forecast, depreciation

Strategy Analysis:

Context for Accounting Analysis

Long Term factors for success Industrial Technologies Group: - Growing high tech materials handling and systems business -Manufacturing firms continued emphasis on cost reduction programs Secure R&D funding, innovation, strategic alliances, skilled staff, etc.

Accounting Analysis

Explanation of transaction 1.
Depreciation is a method that reduces the value of capital assets over time Switch from accelerated to straight line retroactively
Revenues Less: Depreciation Expense = Net Income

Accounting Analysis
Assets
-11.0 Revenue Expense =

1. Change in depreciation method

= Liabilities + Equity
-11.0 N. Income

+11.0

-11.0

Accounting Analysis

Explanation of transaction 2.
Depreciation Expense (Straight Line)
= Capital Cost / Economic Life If the Economic Life is increased then depreciation expense is lowered resulting in higher net income

Accounting Analysis

2. Increase in estimated lives of assets

Assets = Liabilities + Equity

-3.2
Revenue Expense +3.2 =

-3.2
N. Income -3.2

Accounting Analysis

Explanation of transaction 3.
Components of Pension Expense:

Current Service Cost +Interest on Accrued Pension Liability -Expected Earning on Assets +Amortization of start up costs +Amortization of prior service cost from amendments +/- Amortization of actuarial gain/loss

Higher expected earnings produce a lower pension expense resulting in higher net income Expected earnings tied in to general market conditions

Accounting Analysis

3. Increase in rates of return on pension assets

Assets = Liabilities
+ 4.0

+ Equity
-4.0

Revenue -

Expenses +4.0

N. Income -4.0

Accounting Analysis

Explanation of transaction 4.
LIFO (Last In First Out) is a method of valuing inventory where the latest costs of raw materials are used in determining cost of goods sold (it is assumed that the last unit added to inventory is the first sold) Since inventory is liquidated at lower cost than current cost, COGS is lower and Net Income is higher

Accounting Analysis

4. LIFO inventory liquidated

Assets = Liabilities + Equity

-2.4
Revenue Expense +2.4 =

-2.4
N. Income -2.4

Accounting Analysis

Explanation of transaction 5.
Bad debt reserve is an estimate of accounts receivable that will not be collected. In 1983, this reserve was estimated at 10% of accounts receivable. In 1984, an estimate of 6.7% was applied resulting in higher accounts receivable and thus higher net income

Accounting Analysis

5. Decrease in bad debt reserves

Assets = Liabilities + Equity

-2.9
Revenue Expense +2.9 =

-2.9
N. Income -2.9

Accounting Analysis
6. Change in fiscal year Explanation of change: Change of fiscal year from July 31 to September 30. Increase in sales by $5.4 Million Said to provide more timely consolidation with the Corporation

Accounting Analysis
6. Change in Fiscal Year
Assets =

Liabilities

+ Equity

Revenue ?

Expense ?

N. Income ?

Accounting Analysis

7. Drop in R & D Spending Explanation of change: Decrease in R & D expense by $7 million Kobe to reimburse $5.66 million Shortfall of $1.3 million No explicit note about shortfall

Accounting Analysis

7. Drop in R & D Spending

Assets = Liabilities + Equity

-1.3
Revenue Expense +1.3 =

-1.3
N. Income -1.3

Accounting Analysis

8. Transactions with Kobe Explanation of change: Included in net sales were products purchased from Kobe and sold to 3rd parties (vs. gross margin) Said to reflect the nature of the transactions with Kobe

Accounting Analysis
8. Transactions with Kobe
Assets = Liabilities + Equity

Revenue -28

Expense -28

N. Income 0

Accounting Analysis

9. Re-structuring of long-term debt Explanation of change: Subordinated debentures replace term obligations Debt payable in German marks retired The new restructuring said to acquire long-term capital with minimum cash flow requirements to service it

Accounting Analysis

9. Long term debt restructuring

Assets = Liabilities + Equity

?
Revenue Expense ? =

?
N. Income ?

Accounting Analysis:

Comparative Statements
ADJ. 1 2 3 4 % change 44% 13% 16% 10% Effect on N.I. 11 M 3.2 M 4.0 M 2.4 M

5
6 7 8 9 Total

12%
5% 100%

2.9 M
? 1.3 0 ? 24.8+ M

Group Activity

3 Groups: Managers, Creditors, Investors Instructions: Examine how your role would interpret the previously detailed accounting changes, and discuss:
What are the companys rationale/motivations behind the changes? How useful is the information provided by the company about the changes? Discuss if or how the adjustments would affect any business decision you would make on the company?

Group Activity - Summary

Roles influence what information you need for decision making All the accounting changes increase net income Management incentives may be a reason why management made the changes
However, one of the cost cutting measures was to eliminate management bonuses

Financial distress may be another reason why the company made accounting changes, for example, renegotiated loan covenants, etc.

Group Activity - Summary

Big picture shows that there are many possible reasons for the changes Many assumptions are necessary to assess the motivations of management, as you never have the full inside information With limited information you have to consider a wide range of possibilities Need to be flexible, since there are many explanations for accounting changes

Group Activity - Summary

Important to recognize that there are a wide range of reasons for accounting changes Changes in estimates are more difficult to understand than accounting changes and often require additional information

Additional Considerations

Should there be an impairment of assets related to their construction equipment business?

Since the company is stopping the manufacturing of cranes - should there potentially be an increased writedown of assets related to that line of business? There might not be much of a resale market Presentation of Unconsolidated Companies (especially finance company) The relationship with their financing company - Since the company does not consolidate their finance company they could potentially factor receivables and bury any potential bad debt allowance on that line item. It could possibly distort earnings from operations?

Additional Considerations

Given the recovery emerging in the economy, are pension estimates more or less accurate? Research and Development expenditures: Is the company obligated to pay the full 17 million to get any cash back from Kobe? The notes to the agreement presented in the case are a little vague

Future Prospects

The accounting changes increase net income and Harnischfeger hopes that this will encourage investors to boost the stock price Investors may also believe that the changes are part of the entire forward looking business strategy, and thus stock prices may increase An increased stock price may help raise capital in the future
However, if investors have been making adjustments all along to compare Harnischfeger to other firms in the industry, there may be no change in stock price

Future Prospects

Investors may see that the changes have no cash flow implications, or be as a result of management incentives Company went through difficult negotiations with their lenders to make the possibility of bankruptcy more unlikely in the future The company may want to promote itself in a good light with their suppliers, customers, and employees

Future Prospects

The company may want to match external vs. internal reporting standards.
Internal operations seem to be based on industry accounting choices, but external reporting was extremely conservative This may make internal operations more efficient

Same accounting methods as the industry may be necessary since investors may want more information The drop in R&D Improves short-term finance but could possibly impair future prospects for company

Questions?